Tuesday, September 25, 2012

The Reintroduction of National Monetary Policies

I have previously stated that with the introduction of Outright Monetary Transactions (OMTs) the ECB has become the de-facto lender of last resort for Eurozone sovereigns. Before that it was only the lender of last resort for Eurozone banks and did everything to keep solvent banks liquid. Now it also keeps solvent sovereigns liquid and in the eyes of the ECB the solvability of the sovereigns will be assured via the conditionality of an ESM programme. Hence, solvent sovereigns cannot become illiquid anymore and a devastating bank-sovereign default spiral has become a much less likely event.
However, one can also look at the OMTs as providing the ECB with a targeted instrument to conduct a national monetary policy during a period of a renationalisation in financial markets.
Within the Eurozone, financial markets have disintegrated along national lines over the past years. Banks in the core have significantly reduced their holdings of peripheral assets and so did real money investors. On the other side, peripheral banks have increased holdings of domestic sovereign bonds.
Furthermore, the level of monetary accommodation is extremely different depending on the country one is question. The chart below shows the level of yields in Germany and in Spain.

ECB repo rate, Spain & German yields

Source: Bank of Spain, Bloomberg

Hence, the debt crisis has meant that the Eurozone has lost control over the level of yields in the periphery. While the monetary accommodation in Germany increased with every rate cut, the debt crisis led to an ever tighter monetary environment in the periphery. The result of very high yields coupled with a deep recession was that loan growth collapsed.

Yoy loan growth in Spain and Germany

Source: ECB

Prohibitively high yields and significantly negative loan growth mean that the monetary environment in Spain is extremely restrictive while it should have a very accommodative environment. on the other side, Germany with record low yields and moderate but positive loan growth enjoys an accommodative environment. More rate cuts would do not help Spain where monetary accommodation is needed but Germany where it is not. However, OMTs - once Spain or Italy decide to apply for help - will be helping to ease the monetary environment (to be more precise: render it less restrictive) where it is needed most without providing more accommodation where it is not needed.

Hence, the ECB has a tool provide a national monetary policy. While not exactly in the spirit of a monetary union, it will help to ease the burden of adjustment. Furthermore, given that it is a targeted form of monetary policy to be provided where it is needed most, the inflationary risks should be limited. However, it significantly reduces the likelihood that the ECB will continue to provide general monetary easing via another cut in the deposit rate into negative territory.

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About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

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